I have posted on here several times about Burton Malkiel and Charlie Ellis' recent change in their bond portfolio recommendation. They used to recommend Total Bond Market, but now recommended EM bonds, corporate bonds, and dividend stocks.

I was able to get in touch with someone close to them, who has been in the meetings where they have discussed this change.

The main takeaways are that Malkiel and Ellis determined:
1. The Total Bond Market fund will not keep pace with inflation, thus a losing investment.
2. EM bonds and dividend stocks give you better risk adjusted returns.

The last part is the part I'm struggling with. Can someone explain it to me? I still hold BND and I'm very hesitant to make any changes.

Risk-adjusted returns are fairly easy to understand, conceptually. Usually, you can get some kind of return without virtually no fluctuation or volatility, aka "risk." The traditional "riskless asset" is Treasury bills, but if you prefer you can think of a bank account instead.

It's very tempting to point to "S" and say, "it is a better investment, because it had a much higher return." And effectively a lot of people will make that comparison. But the risk matters! At first glance it's hard to figure out how to compare two investments with different return and different standard deviations.

Doesn't it boil down to some subjective feeling about how we feel about volatility?

No, it doesn't, and the key is that we have the R available, and we can mix it in with the riskier investment to equalize the risk, and then compare the return. That's the "risk adjustment."

In this case, we need to cut the risk by 2/3. If we have a portfolio of 2/3 R + 1/3 S,
--The standard deviation will be 1/3 of 12% = 4%
--The return will be 2/3 of the way from "S" to the riskless asset. The difference in returns is 6%, 2/3 of 6% is 4%, the mix will have a return of 7% - 4% = 3%.

Thus "S" has a higher return, but if we equalize risks by mixing R and S, the mix has the same risk as B and it has a lower return.

nisiprius wrote:Risk-adjusted returns are fairly easy to understand, conceptually. Usually, you can get some kind of return without virtually no fluctuation or volatility, aka "risk." The traditional "riskless asset" is Treasury bills, but if you prefer you can think of a bank account instead.

It's very tempting to point to "S" and say, "it is a better investment, because it had a much higher return." And effectively a lot of people will make that comparison. But the risk matters! At first glance it's hard to figure out how to compare two investments with different return and different standard deviations.

Doesn't it boil down to some subjective feeling about how we feel about volatility?

No, it doesn't, and the key is that we have the R available, and we can mix it in with the riskier investment to equalize the risk, and then compare the return. That's the "risk adjustment."

In this case, we need to cut the risk by 2/3. If we have a portfolio of 2/3 R + 1/3 S,
--The standard deviation will be 1/3 of 12% = 4%
--The return will be 2/3 of the way from "S" to the riskless asset. The difference in returns is 6%, 2/3 of 6% is 4%, the mix will have a return of 7% - 4% = 3%.

Thus "S" has a higher return, but if we equalize risks by mixing R and S, the mix has the same risk as B and it has a lower return.

Hence, lower risk-adjusted return.

Thank you very much. Now the concept is clear. But I'm not sure this answers my question about adjusting a bond portfolio this way.

"EM bonds and dividend stocks give you better risk adjusted returns." Ah, verb-tense disease. Does this mean "have given you" or "will give you?" And let's do a reality check. A measure of risk-adjusted return is the Sharpe ratio. Over the past 15 years, according to Morningstar, these are the Sharpe ratios for:

Vanguard Emerging Markets Bond Index fund didn't exist when they wrote the second edition of The Elements of Investing in 2013. They called out iShares J. P. Morgan USD Emerging Markets Bond ETF, EMB for their "surrogate bond portfolio." Unfortunately, that hasn't existed for even ten years, let alone fifteen, so we can't use that one. So I will use the Fidelity New Markets Income Fund, which is an emerging markets bond fund that has existed for fifteen years.

Now, for dividend stocks, the actual fund they called out by name in that book was Vanguard Equity-Income Fund, VEIPX.

So, where are we? Emerging markets bonds and dividend stocks have given us lower, not higher risk-adjusted return. I guess that Malkiel and Ellis predict that in the future, they will give us higher risk-adjusted returns. It's a prediction, not a intrinsic part of the nature of those asset classes.

Finally, let's be perfectly clear. What they are recommending is a big increase in risk in the bond allocation. Which is interesting, because many of us feel that the whole point of the bond allocation is to limit our risk, so we should be thinking carefully before we increase it.

Is the increase in risk serious? Well, instead of looking at standard deviation, let's look at something easy to relate to: what actually happened in 2008-2009. Blue is Total Bond, orange is Fidelity New Markets Income (Emerging markets bond), and green is Vanguard Equity-Income Fund (dividend stocks).

Total Bond almost sailed straight through. About the worst you can say is that $10,000 in Total Bond at the end of 2007 was, at the very lowest point, $9,843 in October, 2008. Less than a 2% loss, and back to over $10,000 within months. The emerging markets bond fund lost 20%. And the Equity-Income fund lost 51% (while Total Stock lost 52%). In short, this fund didn't act like a "bond surrogate" at all, it acted just like stocks.

So, you might decide to take that risk or you might decide not to take it, but there's more risk, really, not just a theoretical technicality.

On a related note Larry Swedroe and others have pointed out that high yield bonds tend to act like stocks especially during market downturns. So just looking at high yield bonds or EM bonds vs investment grade isn't enough. You have to see how it looks when put into your portfolio. And in particular how a portfolio would perform during big crashes like 2008.

nisiprius wrote:...many of us feel that the whole point of the bond allocation is to limit our risk, so we should be thinking carefully before we increase it.

Maybe you could shed some light on that perspective for me. The way I see it you want to get the best risk adjusted return on your portfolio. So lets say you could do that by adding some higher yielding bonds and reducing a little bonds and equities than that's great. I think Swedroe, Vanguard and others argue that it doesn't work but my point is if you can find another asset class that will add better diversification and therefore better risk adjusted returns in a portfolio you should do it even if that means adding something more volatile in place of government bonds.

investorguy1 wrote:
Maybe you could shed some light on that perspective for me. The way I see it you want to get the best risk adjusted return on your portfolio. So lets say you could do that by adding some higher yielding bonds and reducing a little bonds and equities than that's great. I think Swedroe, Vanguard and others argue that it doesn't work but my point is if you can find another asset class that will add better diversification and therefore better risk adjusted returns in a portfolio you should do it even if that means adding something more volatile in place of government bonds.

It is a dangerous game imo. A lot of people have been "seeking" the "best risk-adjusted returns on a portfolio" for generations. This can only be answered in hindsight...pursuing this typically means endless tinkering, performance chasing, increased trading costs, and at the total end of the period, lower returns.

It is also possible to over-diversify, over-complicate and add new emotional factors to your portfolio that many do not realize. You typically get your higher returns from the higher risk asset classes like stocks, and safety plus modest income from bonds. HY are a bit of a hybrid and some people say add them and lower safe bonds and equity allocation, others say you don't need them.

Like many have noted on these forums, when there is a pretty even split from the expert's on the subject, it probably won't matter to your portfolio, so choose what you know will give you a better chance at not messing with.

neomutiny06 wrote:I have posted on here several times about Burton Malkiel and Charlie Ellis' recent change in their bond portfolio recommendation. They used to recommend Total Bond Market, but now recommended EM bonds, corporate bonds, and dividend stocks.

Nedsaid: I could go with corporate bonds coupled with Total Bond. John Bogle recommends something like this. Dividend stocks as a proxy for bonds? No. Dividend stocks are still stocks after all. What Bogle suggests is replacing a segment of Total Stock with higher dividend stocks. Reaching for yield a bit but not too much. EM Bonds? As part of a diversified bond portfolio, yes. As a replacement for Total Bond, no. Really what Malkiel and Ellis are doing is good old fashioned yield chasing and quite frankly they should know better. Not only that, but everybody and their brother has been yield chasing. I just don't think what they are suggesting is a good idea, for one their timing is really bad.

I was able to get in touch with someone close to them, who has been in the meetings where they have discussed this change.

The main takeaways are that Malkiel and Ellis determined:
1. The Total Bond Market fund will not keep pace with inflation, thus a losing investment.

Nedsaid: The inflation hawks are perhaps fighting the last war. There is a good case that deflation and not inflation will be in our future, in which case 2% yields would look awfully juicy. Hard to say if they will be right or not.

nisiprius wrote:"EM bonds and dividend stocks give you better risk adjusted returns." Ah, verb-tense disease. Does this mean "have given you" or "will give you?" And let's do a reality check. A measure of risk-adjusted return is the Sharpe ratio. Over the past 15 years, according to Morningstar, these are the Sharpe ratios for:

Vanguard Emerging Markets Bond Index fund didn't exist when they wrote the second edition of The Elements of Investing in 2013. They called out iShares J. P. Morgan USD Emerging Markets Bond ETF, EMB for their "surrogate bond portfolio." Unfortunately, that hasn't existed for even ten years, let alone fifteen, so we can't use that one. So I will use the Fidelity New Markets Income Fund, which is an emerging markets bond fund that has existed for fifteen years.

Now, for dividend stocks, the actual fund they called out by name in that book was Vanguard Equity-Income Fund, VEIPX.

Vanguard Total Stock Market, VTSMX, scores only 0.40. If Sharpe ratio in the past 15 years is a key criterion, replacing US bonds with EM bonds is unwise, but EM bonds may be an excellent replacement for US stocks.

neomutiny06 wrote:
The main takeaways are that Malkiel and Ellis determined:
1. The Total Bond Market fund will not keep pace with inflation, thus a losing investment.
2. EM bonds and dividend stocks give you better risk adjusted returns.

I'm always very suspicious of people who make both these arguments at the same time.

If you believe that risk adjusted return matters then the second point alone is a necessary and sufficient reason to use EM bonds etc. It means there is an alternative portfolio with the same risk as Total Bond but a higher return. It doesn't matter whether Total Bond loses money or not, the alternative is just plain better, so the first point is irrelevant.

So if somebody makes both points it usually indicates that they don't believe the alternative has a better risk adjusted return, they're just rationalizing reaching for yield.

Maximizing your risk-adjusted returns is not an appropriate goal for most investors. You want to maximize your return for the level of risk you are willing to take. Don't let the Sharpe ratio drive the overall risk of your portfolio.

nisiprius wrote:"EM bonds and dividend stocks give you better risk adjusted returns." Ah, verb-tense disease. Does this mean "have given you" or "will give you?" And let's do a reality check. A measure of risk-adjusted return is the Sharpe ratio. Over the past 15 years, according to Morningstar, these are the Sharpe ratios for:

Vanguard Emerging Markets Bond Index fund didn't exist when they wrote the second edition of The Elements of Investing in 2013. They called out iShares J. P. Morgan USD Emerging Markets Bond ETF, EMB for their "surrogate bond portfolio." Unfortunately, that hasn't existed for even ten years, let alone fifteen, so we can't use that one. So I will use the Fidelity New Markets Income Fund, which is an emerging markets bond fund that has existed for fifteen years.

Now, for dividend stocks, the actual fund they called out by name in that book was Vanguard Equity-Income Fund, VEIPX.

Vanguard Total Stock Market, VTSMX, scores only 0.40. If Sharpe ratio in the past 15 years is a key criterion, replacing US bonds with EM bonds is unwise, but EM bonds may be an excellent replacement for US stocks.

Good analysis.

The first rule of investing is "don't lose money" as are the second and third rules.

nisiprius wrote:"EM bonds and dividend stocks give you better risk adjusted returns." Ah, verb-tense disease. Does this mean "have given you" or "will give you?" And let's do a reality check. A measure of risk-adjusted return is the Sharpe ratio. Over the past 15 years, according to Morningstar, these are the Sharpe ratios for:

Vanguard Emerging Markets Bond Index fund didn't exist when they wrote the second edition of The Elements of Investing in 2013. They called out iShares J. P. Morgan USD Emerging Markets Bond ETF, EMB for their "surrogate bond portfolio." Unfortunately, that hasn't existed for even ten years, let alone fifteen, so we can't use that one. So I will use the Fidelity New Markets Income Fund, which is an emerging markets bond fund that has existed for fifteen years.

Now, for dividend stocks, the actual fund they called out by name in that book was Vanguard Equity-Income Fund, VEIPX.

So, where are we? Emerging markets bonds and dividend stocks have given us lower, not higher risk-adjusted return. I guess that Malkiel and Ellis predict that in the future, they will give us higher risk-adjusted returns. It's a prediction, not a intrinsic part of the nature of those asset classes.

So essentially, their new recommendation is not a permanent portfolio. But more a prediction.

I like the idea of keeping it real simple. The best diversifier of equity risk is high quality bonds. Take risk on the equity side. Rather than messing around by stretching for yield, adjust the stock / bond ratio appropriately and keep the bonds high quality and possibly just short to intermediate term.

I have become of the opinion that Malkiel et al. are being vague because they want people to sign up for their service to get this newfangled superior portfolio they are offering. It surprises me that, whether or not this is their intent, it feels like they are resorting to the old investment sales trick of fear-mongering followed by offering a solution to the problem, but you can only learn the details if you sign up.

I don't think they are advocating replacing a conservative bond portfolio with dividend stocks and EM bonds.

My guess is that they are offering a diversified portfolio of dividend stocks, EM bonds, and conservative US investment grade bonds that they think has an attractive risk-adjusted return. I suspect the recommendation is to hold dividend stocks as one's equity allocation, conservative bonds in the same proportion to equity that you would in an all-index-fund portfolio, but replace some of the equity allocation and some of the bond allocation with EM bonds as a diversifier.

But anytime a strategy is kept a secret, and not subject to the public scrutiny of experts, it should be viewed with some reserve judgment at best, and healthy skepticism or downright cynicism at worst.

If you are worried about a bond portfolio underperforming inflation, the safest solution is to diversify it with some I-bonds and/or TIPs.

jalbert wrote:I have become of the opinion that Malkiel et al. are being vague because they want people to sign up for their service to get this newfangled superior portfolio they are offering. It surprises me that, whether or not this is their intent, it feels like they are resorting to the old investment sales trick of fear-mongering followed by offering a solution to the problem, but you can only learn the details if you sign up.

I don't think they are advocating replacing a conservative bond portfolio with dividend stocks and EM bonds.

My guess is that they are offering a diversified portfolio of dividend stocks, EM bonds, and conservative US investment grade bonds that they think has an attractive risk-adjusted return. I suspect the recommendation is to hold dividend stocks as one's equity allocation, conservative bonds in the same proportion to equity that you would in an all-index-fund portfolio, but replace some of the equity allocation and some of the bond allocation with EM bonds as a diversifier.

But anytime a strategy is kept a secret, and not subject to the public scrutiny of experts, it should be viewed with some reserve judgment at best, and healthy skepticism or downright cynicism at worst.

If you are worried about a bond portfolio underperforming inflation, the safest solution is to diversify it with some I-bonds and/or TIPs.

The strategy is given for free on Wealthfront.com. Take the test and they give you a portfolio.

Everyone faces the full suite of different investing risks, not all of which you have to take and not all of which you have to consider equally important to you. Malkiel and Ellis seem to be making the implicit argument that they believe that the future risk of inflation adjusted loss for treasury dominated bonds is unacceptable for a typical investor to take. Therefore they advocate that the typical investor take more market and credit risk in the expectation of avoiding the loss of purchasing power risk. If that is their argument, if I'm not putting words in their mouths, it would be nice of them to make their argument explicit. We all make risk trade-offs all the time: I'll take more of risk A because I must have less of risk B. It's a perfectly reasonable argument to say I find loss of purchasing power of my bonds to be so dreadful an outcome that I'll bear more of other kinds of risk in order to mitigate the risk I find unacceptable. I don't personally weight my risk tolerance that way and prefer my bonds to be bonds, not stocks. Nonetheless, others may well sleep better at night weighting risks differently. The shortfall in the Malkiel and Ellis advice here is not, I feel, the advice itself, but in obscuring the risk tradeoffs and reasons for those tradeoffs in the program they advocate. If they were explicit, people could more easily ascertain if the reasoning applied to their own situations and risk preferences.

asset_chaos wrote:We all make risk trade-offs all the time: I'll take more of risk A because I must have less of risk B.

Yes, exactly. Also note that the usual calculation for the Sharpe ratio is based in the standard deviation, a simplistic, one-dimensional measurement that in no way reflects these kinds of trade-offs. Any estimates of risk-adjusted returns that do try to take these into account will necessarily be imprecise, because we have no good way to quantify many of these risks. Beware of false precision.

I think this is exactly the kind of advice that causes investors to make emotional mistakes. Here are the "experts" telling us to sell bonds and buy stocks because it's really safer. Once I hear something like that, I stop listening.

Paul

When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

For the sake of discussion, let me propose a couple of ways of thinking about it that are different from the trend of this and most threads on this matter:

1) I think it's been said before that one should look at their entire portfolio and not pieces in isolation. What someone can do if they increase their risk in bonds is to reduce their risk in stocks at the same time.

In 2008, a 60/40 portfolio of Vanguard Total Stock and 40% Vanguard Total Bond lost 19.2%.

Suppose one has been using intermediate term investment grade (i.e. riskier bonds) but compensated by using Vanguard Dividend Appreciation index fund for stocks (i.e. lower volatility stocks). A 60/40 mix of those stocks and bonds lost 19.6%.

In short, if one thinks that the first option is not one they want to adopt, then they can do something like option B without changing their overall portfolio risk in a significant way.

2) We often talk about one's need, willingness, and ability to take risk. If inflation is 0% and savings accounts are paying 10%, why would anyone invest in stocks? There is no need to take risk. If inflation is 3% and bonds are yielding 1%, that creates a situation where you might need to take more risk to get the returns you are after. It may not be what you want to do, but you have to live in the world that actually exists and not the one you would like to exist.

Are we perhaps too quick to argue that people are acting in bad faith when they are just making an observation that many people need to take more risk nowadays because the interest rate world we live in is fundamentally different than it was in the 80s and 90s? The appropriate amount of risk that one should take is not fixed for time and eternity but depends on circumstances, both personal and economic.

Are we perhaps too quick to argue that people are acting in bad faith when they are just making an observation that many people need to take more risk nowadays because the interest rate world we live in is fundamentally different than it was in the 80s and 90s?

Taking more risk is not the solution. The solution is in recognizing that it is real returns and not nominal returns that matter.

jalbert wrote:I have become of the opinion that Malkiel et al. are being vague because they want people to sign up for their service to get this newfangled superior portfolio they are offering. It surprises me that, whether or not this is their intent, it feels like they are resorting to the old investment sales trick of fear-mongering followed by offering a solution to the problem, but you can only learn the details if you sign up.

I don't think they are advocating replacing a conservative bond portfolio with dividend stocks and EM bonds.

Nedsaid: I think you are absolutely right. If they actually did this I can just imagine the lawsuits if things really went south for the "bond replacements." I think they will add a sprinkling of dividend stocks and EM bonds to add spice to what would otherwise be a very conventional portfolio. Makes things interesting but neither would help or hurt too much.

My guess is that they are offering a diversified portfolio of dividend stocks, EM bonds, and conservative US investment grade bonds that they think has an attractive risk-adjusted return. I suspect the recommendation is to hold dividend stocks as one's equity allocation, conservative bonds in the same proportion to equity that you would in an all-index-fund portfolio, but replace some of the equity allocation and some of the bond allocation with EM bonds as a diversifier.

But anytime a strategy is kept a secret, and not subject to the public scrutiny of experts, it should be viewed with some reserve judgment at best, and healthy skepticism or downright cynicism at worst.

Nedsaid: The cynic in me would say the way to approach fear and uncertainty about the future is to throw more asset classes at it. It makes you think you are "doing something." I have probably done this myself in the past. With asset classes, there seems to be safety in numbers or at least an illusion of safety. The more, the seemingly better.

If you are worried about a bond portfolio underperforming inflation, the safest solution is to diversify it with some I-bonds and/or TIPs.